When the Market Environment Gets Stormy, Rely On Your Instrument Panel

Turbulent winds of change have been blowing over the past month, unsettling many investors. What do the latest developments mean? Should you make adjustments to your investing strategy? And if so, what would they be? If you could come into my office, I would answer your questions and perhaps allay some of your concerns. Short of that, let me try to put recent events into perspective. Here's what I think you should know.

• About the debt-ceiling debate. It was a given that Congress would raise the federal debt limit and avoid default. However, it did not need to be done before August 2. Default was never in the cards because the Treasury receives more than enough money each month to make payments to cover the interest on our debt, Social Security, Medicare, and military salaries. True, agency budgets would get shortchanged and there would be a temporary "government shutdown" such as we saw in 1995 and 1996. Exaggerating the significance of the August 2 date wasn't helpful, and the American people were caught in the rhetorical crossfire.

• About the debt-ceiling compromise. The legislation passed by Congress didn't address the core issues. As Sen. Tom Coburn, who voted against the legislation, pointed out, "It eliminates no program, consolidates no duplicative programs, cuts no tax earmarks and reforms no entitlement program." The much publicized "cuts" are merely reductions in the growth of spending.

• About the downgrade of U.S. credit worthiness. Because spending will continue to rise year after year, Standard & Poor's rating service downgraded U.S. debt from AAA status to AA+. Investors didn't take the downgrade seriously, as evidenced by the huge rally in Treasuries in the aftermath. When investors worldwide are frightened, they still turn to U.S. Treasuries, regardless of what S&P thinks of their safety.

• About the continued rise in gold. This, too, was fueled by the failure of the debt-ceiling compromise to reduce spending. Investors continue to look at gold as a hedge against the decline in value of fiat currencies such as the dollar and euro. (See Gold Revisited. )

• About the extreme market volatility and fears of a bear market. In early August we had major daily moves — down, then up, back down, and finally up — all back to back. I don't know if the pessimism of the sellers was warranted. Time will tell. What I do know is that, historically, we have had a bear market in the U.S. every three to four years. And it may well be time for the next one — not necessarily because the world economy is about to crash, but because the market always cycles between bull markets and bear markets. If you're going to be an investor over a span of many decades, you're going to have to weather a number of bear markets.

It would be nice if things settled down over the next few weeks, but don't rely on that to calm your emotions. Rather, you should rely on the discipline imposed by a structured, proven approach to risk management to save you from your emotions and counterproductive buying/selling. Such an approach means:

• You should continue following your personalized long-term plan. Hopefully, you have followed our advice and developed one, preferably at a time when your emotions weren't screaming at you. The past few weeks have illustrated the importance of setting your stock/bond mix appropriately . It should balance your need for growth with your fear of loss. If set correctly, then times like these can be weathered financially and emotionally. While you might reasonably be concerned about the recent developments, you shouldn't be losing sleep.

• If you are regularly putting money into stocks, you should continue doing so. A dollar-cost-averaging (DCA) strategy is quite effective at helping the average investor build his or her portfolio over time (see How to Make the Stock Market Less Frightening ). When stock prices are low, you get even more for your money. Periods of weakness are seasons of opportunity for the investor using a DCA approach.

• If you're fretting over the risks of a new bear market, you should prepare now for an orderly adjustment in your stock holdings. Read "On Bear Markets and Boundaries " where a strategy for reducing risk during bear markets is explained. It will help you decide what action to take now that SMI's "Bear Alert " has been triggered.

• If you're following SMI's Upgrading strategy, you're already taking steps to gradually reduce risk by selling riskier funds and buying more conservative ones. See this month's new fund recommendation write-ups  for more information on how Upgrading accomplishes this for us automatically.

When market storms come — and you can be certain that they will — it's important that you trust your instrument panel rather than flying by the emotion of the moment.

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

• SMI Editorials page

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